When Do You Need to Pay Withdrawal Penalties?

Accessing retirement savings before a certain age can be a complicated financial decision. The government provides tax advantages for these accounts to encourage long-term saving, so early withdrawals often trigger penalties. While the rules apply broadly across different types of retirement plans, they are also accompanied by a significant number of exceptions.

The 10% Early Withdrawal Penalty Rule

The primary rule for most retirement plan distributions is based on age. If you withdraw funds from your account before reaching age 59½, the taxable portion of the withdrawal is subject to a 10% additional tax. This penalty is applied on top of the ordinary income taxes you will owe on the withdrawn amount.

This rule applies to a wide array of accounts, including traditional IRAs, SEP IRAs, and employer-sponsored plans like 401(k)s and 403(b)s. The 10% penalty is calculated only on the portion of the distribution that is includible in your gross income.

If you have made non-deductible (after-tax) contributions to a traditional IRA, the withdrawal of those specific contributions is not subject to the penalty because they are not taxable. The penalty is aimed at the tax-deferred growth and pre-tax contributions.

Exceptions for Avoiding the Penalty

The tax code provides numerous exceptions that allow for penalty-free access to retirement funds before age 59½.

• Distributions made due to a total and permanent disability.
• Withdrawals for an individual certified by a physician as having a terminal illness expected to result in death within 84 months.
• Payments for unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI).
• Funds used to pay for health insurance premiums after receiving unemployment compensation for 12 consecutive weeks.
• Withdrawals up to $22,000 by individuals affected by a federally declared disaster.
• Distributions up to $10,000 or 50% of the account value, whichever is less, for victims of domestic abuse.
• Withdrawals up to $1,000 for personal or family emergency expenses.
• Distributions up to a lifetime limit of $10,000 from an IRA for a first-time home purchase. A first-time homebuyer is someone who has not owned a primary residence in the past two years.
• Funds used to cover qualified higher education expenses for yourself, your spouse, children, or grandchildren.
• Distributions made to a beneficiary after the death of the account owner.
• Withdrawals to satisfy an IRS levy on your account.
• Penalty-free withdrawals of up to $5,000 per parent for expenses related to a qualified birth or adoption.
• Distributions taken as part of a series of substantially equal periodic payments (SEPP) based on life expectancy.

Withdrawal Rules for Specific Account Types

Roth IRA

Roth IRAs have unique withdrawal rules. When you take money from a Roth IRA, the first dollars withdrawn are your direct contributions. Because these are made with after-tax money, you can withdraw them at any time, at any age, completely tax- and penalty-free.

After you have withdrawn all contributions, the next funds distributed are converted amounts, followed by investment earnings. Only the earnings portion is potentially subject to taxes and the 10% early withdrawal penalty. For earnings to be withdrawn tax- and penalty-free, the distribution must be qualified, meaning you are at least 59½ and have had a Roth IRA open for at least five years.

SIMPLE IRA

SIMPLE IRAs have a 2-year rule. If you take a withdrawal from a SIMPLE IRA within the first two years of your initial participation, the early withdrawal penalty is increased from 10% to 25%. This two-year period begins on the day your employer deposits the first contribution.

This heightened penalty applies only if you are under age 59½. After two years, the penalty for early withdrawals reverts to the standard 10%.

457(b) Plans

Distributions from governmental 457(b) plans are not subject to the 10% early withdrawal penalty, even if taken before age 59½. This exception applies once you have separated from service with the employer sponsoring the plan. While the penalty is avoided, these withdrawals are still subject to ordinary income tax.

This feature makes 457(b) plans a flexible option for public sector employees. The penalty exemption does not apply to funds that were rolled into the 457(b) plan from another account type, like a 401(k) or IRA.

How to Report Withdrawals and Claim Exceptions

Form 1099-R

After you take a distribution from a retirement plan, the plan administrator will send you Form 1099-R. This form reports the total amount of the distribution and the taxable amount. Box 7 contains a distribution code provided by the payer that indicates the reason for the distribution.

For example, a Code 1 signifies an early distribution with no known exception, meaning the 10% penalty likely applies. A Code 2 indicates an early distribution where an exception applies, while other codes denote specific reasons like disability (Code 3) or death (Code 4). You will use this information to correctly report the income on your tax return.

Form 5329

If you owe the 10% additional tax, or if you qualify for an exception not indicated on your Form 1099-R, you must file Form 5329. This form is used to calculate and pay the 10% penalty or to formally claim an exception. If your Form 1099-R has a Code 1 in Box 7 but you meet an exception’s criteria, you will file Form 5329.

On this form, you enter the distribution amount and the corresponding exception code from the instructions, such as code 09 for a first-time home purchase. Filing this form ensures you correctly report your situation to the IRS.